State bonds in turmoil as debt crisis spreads

State treasurers have warned of ­rising borrowing costs as the ­European debt crisis forces investors to dump their bonds indiscriminately, driving up yields on their securities.

Amid an escalation of the crisis, which is also increasing the funding costs of Australia’s largest commercial lenders towards gloomy 2009 ­levels, safe-haven buying has driven 10-year commonwealth government bond yields below the 4 per cent mark for only the second time in ­history.

But state government bond yields have remained stuck as the flight to safety has led the region’s central banks and sovereign wealth funds to switch out of semi-government bonds and into safer sovereign commonwealth government bonds. This has forced up state credit spreads, increasing the cost of issuance.

Queensland Treasurer
Andrew Fraser
said the continued uncertainty in Europe was making it harder to sell state bonds.

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“It’s a challenging time for markets everywhere. [Queensland], like other sovereign and semi-sovereign issuers, is getting caught in the crossfire," he said.

Mr Fraser said Queensland Treasury Corporation completed more than half of its 2011-12 borrowing program before the overseas sovereign debt concerns began to dominate market sentiment.

On Friday, Queensland bonds maturing in 2020 traded at a yield of 5.02 per cent compared with the government bond rate of 3.6 per cent, a record gap of 1.4 percentage points.

South Australia’s bonds also underperformed following comments that the state could suffer a credit rating downgrade.

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“These are difficult times and the markets are acting unpredictably. We obviously continue to monitor developments closely," Mr Fraser said.

“Global markets need to take strong action, as their inaction is ­having consequences for the broader sovereign market.

“At this stage we remain positive in terms of meeting our funding targets in the market, but we’re not under­estimating the current difficulties."

The bonds of Victoria and NSW were among the better traded state bonds in a brutal week for the sector but also substantially under­performed the rally in Aust­ralian ­federal government bonds.

“We remain in a relatively strong position and certainly recent market commentary supports the quality of the Triple-A [credit rating] in NSW on the back of new fiscal measures that we’ve introduced in the past few months," NSW Treasurer
Mike Baird
said.

“One of the big advantages we have is that our current maturity profile is longer than it has been, so we don’t have as many refinances coming up and that puts us in a good position."

But in Western Australia, with arguably the best financial position, the impact has been muted so far.

WA Treasurer
Christian Porter
said the impact of the turmoil on the state’s bonds had been limited, with a small widening in the spread to Commonwealth securities being offset by a fall in the overall level of interest rates on the state’s bonds since ­October.

“The Western Australian Treasury Corporation [WATC] has not observed any switching out of its bonds into Commonwealth government bonds and has continued to raise funds to meet its lending obligations to its clients," he said.

“Whilst overall spreads between the yields on semi-government and commonwealth bonds have increased, the corporation’s bond yields have in fact fallen by 30 to 50 basis points since the end of October compared with 60 to 90 basis points for the commonwealth.

“It is the WATC’s view that is reflective of relatively stronger demand from investors for ­commonwealth bonds in the ­current market. Whilst market ­conditions are tight and are likely to continue, WATC does not expect any problems with raising its borrowing program this year."

While absolute bond yields on state bonds have remained relatively steady, most semi-government bond investors track the credit spreads, which are widening.

“The thing that concerns us about the spread volatility is that it feeds on itself and makes investors nervous," said Stephen Knight, chief executive of NSW Treasury Corporation.

He said the brutal widening of state-government bond spreads and other bonds was partly the result of reduced liquidity as brokers and dealers scaled back their market making activities.

The trading desks at major banks that are relied upon to buy and sell bonds have had a particularly ­challenging year, reflected in sharp declines in revenue as a result of losses from trading interest rate ­securities.

“As a result the banks currently have less capacity or appetite to apply risk capital to support market making which is as challenged as I can remember," Mr Knight said.

“It means that you can get a very quick loss of liquidity because the intermediaries don’t have that appetite to carry inventory or quote fine prices."

It’s not the first time state-government bonds have been left behind in the rush to safe-haven assets. In August state government bond spreads underperformed the federal government inflicting large losses on the banks. But the state-governments do benefit from the fact that the nation’s large banks are encouraged to hold semi-governments as part of a required portfolio of liquid assets to meet international regulatory standards.

Bond price movements in the wholesale debt markets has also been unprecedented.

In August the spread widening of semi-government bonds compelled banks to buy into the market as they have to own a certain proportion of semi-government bonds.

As wholesale bond markets have traded erratically, leading to violent swings in funding costs, Australian retail investors’ interest in fixed income type investment has increased steadily. Woolworths hybrid notes performed strongly on their first day of trading as investors searching for alternative investments to shares bid for the securities. The rise of retail interest in fixed income may vindicate NSW Treasurer Mike Baird’s decision to set up the Waratah retail bond program.

“Diversification is a critical thing, and it’s part of the reason why I was advocating entry into the retail market in a more aggressive way [through Waratah bonds], said Mr Baird.

“I think that the measures we’ve taken, both the Premier and myself, talking to institutional investors across the Asia-Pacific ... have positioned us well. It’s raised awareness across some of the largest institutions in the Asia-Pacific on the new NSW story."